Fiscal Crisis Leaves Stocks in a Sweet Spot

The Washington mess of the past few weeks was ugly and disruptive for financial markets. It could do more damage in December as investors contemplate resumed acrimony when 2014 arrives.

Yet it all has a silver lining. ‪

The federal government’s shutdown and threat of default on U.S. debt spawned anxiety among businesses and consumers, hurt the U.S.’s image around the world and took about half a percentage point off fourth-quarter economic growth, economists estimate.

But the economy kept growing. Inflation stayed low. And the turmoil is widely expected to keep the Federal Reserve more supportive of the economy and markets than money managers had anticipated until recently.

‪Analysts who have studied past market behavior say that backdrop—moderate economic growth with low inflation and strong central-bank backing—is excellent for stocks. That may help explain why financial markets remained fairly calm throughout the crisis and how the S&P 500 stock index finished Friday at 1744.50, a record high. The S&P 500 is up 22.3% this year.

“This is the best environment for stocks right now. You don’t have rising interest rates becoming a problem. You don’t have inflationary pressures. You do have earnings growth,” said Tim Hayes, chief global investment strategist at Ned Davis Research in Venice, Fla. ‪The firm has studied stock performance in a wide variety of economic environments going back decades.

‪One of the most positive indicators today, Mr. Hayes said, is that unemployment is a high 7.3%, but declining. ‪

“When the unemployment rate is above 6% and falling, that is the best situation for the stock market” based on the performance of the S&P 500 back to the 1940s, Mr. Hayes said.

Stocks average 13.5% annual gains when unemployment is above 6%, and 16.5% when the rate is that high and falling. Joblessness isn’t good for ordinary people, of course, but stocks respond more to expectations for corporate earnings, inflation, interest rates and the like.

High unemployment is good for stocks if it holds down labor costs. High but falling unemployment is even better because it keeps a lid on costs and fuels consumer-spending growth, as expanding employment puts money in people’s pockets. ‪

Stocks also do better when earnings growth is below 5% on a year-over-year basis than when it is above 5%, according to the Ned Davis studies. That is because moderate earnings growth is less likely to spur inflation or push interest rates higher.

‪Another big boost for stocks is the growing hope that low inflation and worries about economic growth will induce the Federal Reserve to keep stimulating the economy by holding down long-term interest rates.

‪Over the summer, many investors expected the Fed would decide in September that the economy was strong enough for it to cut back on its $85 billion in monthly bond-buying stimulus. Then the Fed surprised investors and analysts by delaying action, citing among other things the risk to growth from Washington’s fight over debt and government funding.

‪Now, many economists think the Fed could hold off until the end of the year or longer. Laurence Fink, chairman and chief executive of BlackRock Inc., which oversees $3.8 trillion and is the world’s biggest asset manager, as well as other well-known Wall Street executives and investors, have predicted that the Fed could wait until March or even June. ‪

Mr. Fredericks also has studied the market’s behavior during varying economic circumstances. He agrees with Mr. Hayes of Ned Davis that low inflation and low labor costs help stock performance. Mr. Fredericks believes strong growth is better than slow growth, but the two men define slow growth differently, making it hard to compare their views. The two agree on the Fed’s importance to continued stock gains, especially now. ‪

“We think a lot of this comes down to just the importance of central-bank policy,” Mr. Fredericks said. ‪

A big question for the future, he said, is how and when central banks around the world unwind their financial stimulus. ‪Mr. Hayes thinks how that is handled could determine when stocks next face a bear market, most commonly defined as a 20% decline from a high. ‪While he is optimistic about the immediate future, he said he wouldn’t be surprised to see stocks pull back by next summer.

Such a decline is common after stocks have risen strongly for years, Mr. Hayes said. That is especially true when stock prices are above average when compared to corporate earnings, as they are today. The S&P 500 trades at more than 18 times its component companies’ earnings for the past 12 months, above the historical average of about 16. ‪

“I wouldn’t be surprised if we see a cyclical bear market next year” or at least a sharp decline, Mr. Hayes said.

His best guess about the trigger: continued stock gains that make the market look expensive whenever the Fed finally trims its bond-buying stimulus and pushes long-term interest rates higher.

But as long as inflation remains low and the economy is growing, any pullback could be brief, he said. The economic backdrop would support renewed stock gains, assuming Washington isn’t back in crisis when the Fed is withdrawing stimulus.

Eventually, dysfunction in Washington is bad for the stock market and economy, said Mark Zandi, chief economist at Moody’s Analytics. ‪

For years, the ability to cut labor costs has helped companies remain profitable despite limited business investment, he said. Now, wages and hiring are on the rise. Future business success depends on expansion and investment. Stocks seem to be shrugging off Washington’s acrimony in the short run, but in the longer run it damages business confidence and limits investment, Mr. Zandi said.

‪“I’m not sure I draw the conclusion that this kind of climate is good for business and stock investors in the long run,” he said.